One of last year’s best trades was buying McMillan Shakespeare after the previous Federal Government proposed changes to FBT exemptions on company cars. The shock decision saw McMillan crash from a 52-week high of $18.54 to $6.75 in late July.
McMillan quickly became a proxy on how the sharemarket predicted the Federal election result. Those who believed Labor would lose, and that a newly elected Coalition would kill the proposal, were handsomely rewarded. McMillan doubled to more than $13 between July and September.
The share-price bounce implied everything was back to normal for McMillan – or at least would be by the FY15 result. But it has since drifted to $9.62, after reporting a 35 per cent drop in net profit for the first half of FY14. Ongoing regulatory risk in McMillan is worrying investors.
The threat is the Federal Government changes the taxation regime for fringe benefits tax (FBT) exemptions for employees of not-for-profit enterprises, and for employees who take out novated leases on cars. In novated leases, an employer pays for vehicle and running costs from the employee’s pre-tax salary.
McMillan, and the salary-packing industry for that matter, relies on these exemptions. On some broker estimates, up to three-quarters of its earnings would be affected by any changes. McMillan’s three-month rolling revenue tumbled after the proposed changes to FBT on motor vehicles in July last year.
Optimists hope the Federal Government keeps the status quo on FBT exemptions on novated leases, and in the NFP sector. It fiercely criticised the previous government’s proposed changes and proclaimed the FBT impost on the motor vehicle industry was “dead and buried”.
That was before the economy slowed, pressure on the Federal Budget intensified, and the announced exits of Holden and Toyota from Australian-based car manufacturing by 2017. The Government had argued that favourable tax treatment on novated leases supported the local car industry. It was right: sales of company-car fleets dropped sharply after the Rudd Government announced the proposal.
Although regulatory risk has increased, it is not new for McMillan. This risk has swirled around the stock for several years, with various taxation reviews and forums floating the idea of changing the FBT framework for novated leases. It is proving a hard exemption to kill.
My view is it is not a question of whether the exemptions will go, but when and by how much. The market might have become too pessimistic on McMillan and is pricing in the downside too early.
I cannot see the Federal Government picking a big fight with the NFP sector over FBT exemptions, at least until after the next election. It has already raised the ire or some of Australia’s biggest charities with its plan to shut down the charity regulator, the Australian Charities and Not-for-Profits Commission. Going after FBT exemptions for underpaid NFP workers is a risk.
Changes to novated leases could be part of the taxation review the Federal Government takes to the next election. The worst-case scenario is the exemptions are axed or wound back. The medium-case scenario is the exemptions are phased out over several years. The best-case scenario is no change at all.
I’m plumping for the medium-case scenario – proposed taxation changes taken to the 2016 election, implemented the following year, and some FBT exemptions phased out or wound back over a few years after that. Potentially, any significant changes to McMillan’s earnings could be years away. And there is still a fair chance that the status quo will continue, meaning the market is too pessimistic on McMillan.
The great challenge for value investors is buying exceptional companies at bargain prices. McMillan, if not exceptional, has been a consistently strong performer, and its move into the United Kingdom has long-term potential. It is no fluke that the company has become Australia’s largest salary packager, and for a time was among the market’s highest-rated small-cap companies.
The salary packaging industry still has good prospects. Macquarie Equities Research this week wrote employment growth, particularly in health and education, growth in new vehicles sales, outsourcing of fleet management. and increased customer penetration and new products, will drive growth in salary packaging and leasing.
McMillan looks reasonable value for long-term investors who can tolerate higher risk, and keep a close watch on any talk about changes to FBT exemptions. They will need to move quickly if the market becomes spooked that FBT changes are back on the agenda.
Morningstar’s fair value for McMillan is $11 a share. In some excellent research on the stock, investment bank CLSA has a $12.60 share-price target and outperform rating for McMillan. Macquarie’s 12-month target is $12.31. At recent prices, that suggests a 25-30 per cent gain over a year.
CLSA wrote: “At current levels, we argue that the market is fully pricing in what we see as the worst-case scenario for novated leasing. It is attributing significant risk to changes in NFP FBT exemptions, which we still regard as unlikely.”
My sense is McMillan will get a touch cheaper before it retests prices around $13. It is hard to see a re-rating catalyst given uncertainty around the upcoming Federal Budget, and the market’s desire to see McMillan’s full-year result and ensure its earnings are back on track.
Either way, McMillan deserves a prime spot on portfolio watch lists. This is a high-quality, well-run company trading at half its peak valuation, largely over speculation of a FBT changes that are still far from certain, and most likely years away from full implementation should they proceed.
Tony Featherstone is a former managing editor of BRW and Shares magazines. The column does not imply any stock recommendations. Readers should do further research of their own or talk to their financial adviser before acting on themes in this article. All prices and analysis at April 3, 2014.
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